from Follow the Money

Worth less, not worthless

March 2, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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I am glad Mr. Buffet clarified that. Project out last weeks trends for very long and there might be a bit of doubt.

Mr. Soros wasn’t as kind.

""The dollar is a terribly flawed currency"

Nor, for that matter, was Robert Lynch of HSBC:

"the dollar is basically being re-rated ... in much the same way many U.S. credit derivative securities have been re-rated."


Joanna Slater and Craig Karmin are a bit kinder. They compare the dollar to Windows. Unloved, but impossible to avoid.

"for all of the gloom, the world is unready to let go of America’s unloved dollar. Akin to the way Microsoft’s often-criticized Windows operating system remains indispensable to the majority of computer users, the dollar remains the common language of finance, the medium of exchange in everything from sugar to wheat to oil."

I have no particular insights into the causes of the dollar’s big fall last week.

At the same time, I don’t think its weakness since last August should be a mystery. Robert Lynch wasn’t far off the mark: the dollar’s weakness fundamentally reflects the collapse in demand for securitized US credit.


For much of this decade, financial engineering was to the US what automotive engineering was to Germany. Mortgage-backed securities were the United States leading export -- by a large margin. Those securities no longer command a premium in the global market. Indeed, they can only find buyers if they carry an Agency guarantee.

That has consequences.

1/ The collapse in demand for complex securities has reduced overall foreign demand for US financial assets. There was a time when serious observers - including observers at places like the IMF -- argued that the United States comparative advantage at creating complex financial "products" would assure demand for US dollars and the financing of the US current account. That forecast hasn’t been born out. Foreign demand for US equities has emerged, but that demand hinges on getting those assets at a sale price.

2/ Sharp falls in the market price of a range of complex securities have seriously dented the capital base of the US banking system. It turned out that not all -- and perhaps not even a majority -- of subprime debt has been shipped abroad. A lot remained on the books of the banks and broker-dealers. The large resulting losses forced the large banks and broker-dealers to turn to the Gulf, Singapore and China (and to a lesser degree Korea and New Jersey) for new capital. Real estate losses could lead some smaller banks to fail. The big banks -- even after getting a few petrodollars -- are now unwilling to commit their now scarce capital to backstop something like the auction rate security market.

3/ Capital constraints and a closed market for most forms of securitized housing credit -- at least housing credit that lack an Agency guarantee -- seem to have slowed the US economy. The combination of a slowing economy and a weak banking sector which would benefit from a upward sloping yield curve makes it hard for the Fed not to cut interest rates. And lower rates don’t help the dollar -- particularly against the yen.

4/ Lower US rates though imply even looser monetary conditions than is already the case in high-growth, high-inflation countries that currently still peg to the dollar. Real rates in the Gulf and China are now quite negative. That fuels their growth -- and their demand for commodities. Decoupling isn’t good for the dollar; investors generally prefer to finance rapid growth rather than a slowdown. And right now the rapid growth in the dollar zone isn’t found in the US.

5/ The combination of a slowdown and rising prices (notably commodity prices) has forced the Fed into a difficult position. See Dr. Hamilton or Dr. Duy. Opting to focus on limiting the risk that US output will fall too sharply rather than the risk that inflation will remain high is the right choice (in my view), but it nonetheless has consequences. America’s foreign creditors are seeing the US purchasing power of their dollar holdings fall along with the global purchasing power of their dollar holdings.

Central banks though are the one group of American creditors who do not seem to have lost their appetite for dollar-denominated securities. They are a tolerant group. The Fed’s custodial holdings continue to rise.

Dollar reserve growth almost certainly set a record in 2007. And - barring a big shift to sovereign wealth funds -- I would bet 2008 will be similar.

Just as the market for housing finance has been "effectively nationalized," so too has the financing of the US current account deficit. The Agencies are now big buyers of US mortgages. Central banks are big buyers of Agency securities. Treasuries too.

As a result of this intervention, the dollar isn’t uniformly weak. It unremains fairly strong against many emerging currencies. Something of a rebalancing which left the emerging world with stronger currencies, less inflation and more external purchasing power and Europe with a somewhat less appreciated exchange rate likely would be better than the world we now have. The emerging world would have less inflation, Europe would have better prospects for growth and the US trade deficit might start to come down against the fastest growing parts of the world economy -- not just Europe and Canada.

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